Money and Banking Lecture 9 (University of Amsterdam 2024-2025)

Lecture 9 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics 1. The co...

Lecture 9 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics 1. The concept of money 2. Measuring money 3. Controlling the monetary base 4. The money supply process -2- Concept of Money Economists’ definition of money (also referred to as money supply): Anything that is generally accepted in payment for goods and services and in repayment of debts. -3- Functions of Money 1. Medium of exchange: used to pay for goods and services. Eliminates the trouble of finding a double coincidence of needs and as such reduces transaction costs, enables specialisation and increases efficiency. As a medium of exchange money must: be easily standardised; be widely accepted; be divisible; be easy to carry; not deteriorate quickly. 2. Unit of account: used to measure value in the economy. 3. Store of value: used to save purchasing power over time. Money is the most liquid of all assets but loses value due to inflation. Liquidity here is the ease and speed at which an asset can be converted into the medium of exchange and money obviously is the medium of exchange. -4- Evolution of the Payments System The payments system: method of conducting transactions in the economy. It is not rigid but evolves over time and can strongly differ across countries: 1. Commodity money: precious metals such as gold and silver. 2. Fiat money: paper money decreed by governments as legal tender. 3. Cheques: instruction to your bank to transfer money from your account. 4. Electronic payments such as online payment of bills. 5. E-Money (electronic money): Debit cards, stored-value cards, smart cards, E-cash, bitcoin as well? (see next slides), … -5- Brief Excursion: Bitcoin Is has no central administrator. It consists of two elements: o an append-only publicly viewable collection of records (i.e., a database or ledger), and o a set of rules that govern the ledger’s organisation and updating. The bitcoin system consists of a decentralised network of computers that maintain and update a copy of the ledger in accordance with the protocol. These are the so-called “miners”. The “miners” spend (huge) computational resources in a process called “Proof of Work”. They participate in a lottery in which they can win newly created bitcoins. The total supply of bitcoins will be limited to 21 million (19.6 million had been mined by January 2024). -6- Brief Excursion: Bitcoin Attractive for: o people that seek an asset of which the supply cannot increase indefinitely. Think of for instance residents of high-inflation countries in which the legal tender rapidly loses value (e.g., Venezuela). o “libertarians” and “privacy lovers”: the bitcoin bypasses the public and banking sectors (cf. the distrust after the Global Financial Crisis): transactional anonymity. o suppressed communities that value anonymity (e.g., LGTB in certain countries): transactional anonymity. Note: opening an account at an “exchange” where bitcoins can be exchanged for US-dollars for instance requires an ID (“know-your-customer requirement”). -7- Brief Excursion: Bitcoin o unbanked population (63% in Mexico, 60% in Nigeria, 7% in the US). o financially underdeveloped regions (regions with few banks, few ATM, etc.). o those seeking speed and low costs in (international) transactions (at least for peer-to- peer transactions, not (yet) for conversions of bitcoin into Euro, etc). o illegal activities (dark web, payments to unlock ransomware, money laundering, …). -8- Brief Excursion: Bitcoin Its value is highly volatile. For instance, daily movements of +6% or -6% vis-à-vis the US-dollar and the Euro are not uncommon. -9-  Brief Excursion: Bitcoin The bitcoin has only come some limited way towards fulfilling the three functions of money: o Medium of exchange: some retailers accept bitcoin (although some have stopped accepting it in view of the high volatility in its value). The slow processing of moves from bitcoin into Euro, etc, and vice versa, further limits its attractiveness in this aspect. o Unit of account: virtually absent due to the large volatility in its value (e.g., letting one’s wages be expressed in bitcoin is probably not very attractive). o Store of value: probably the most important function now. Use as a speculative instrument in order to benefit from (proclaimed) expected increases in its value and/or to benefit from the substantial daily movements in its value (“buying at the low and selling at the high”). The bitcoin therefore is rather to be referred to as a “crypto asset” rather than as a “cryptocurrency”. - 10 - Brief Excursion: Bitcoin The main attractive feature probably is its decentralised nature, but the decentralised nature is also its main weakness: o The bitcoin is not backed by any (monetary) authority (no legal tender, no stabilisation of its value, no deposit guarantee system, etc.). o It has value as long as others accept it for transactions (this feature also applies to local/community currencies) and/or as a store of value. Example of a local/community currency: the Brixton Pound. - 11 - Brief Excursion: Bitcoin The bitcoin has in the meantime become an additional legal tender in two countries: o El Salvador (since September 2021): next to the US dollar (El Salvador dollarised in 2001): it seems that the bitcoin is not widely used nor widely accepted in the country. o Central African Republic (April 2022-Spring 2023): next to the Central African CFA franc (which is pegged to the euro): it seemed rather a (geo)political statement in a country in which the availability of the internet is very limited. - 12 - Measuring Money The definitions of the so-called monetary aggregates differ across countries and vary over time. Reasons: 1. Differences in what members of each society accept as a medium of exchange. 2. Due to financial innovations, some assets are accepted as money in some societies but not in others or are no longer accepted. 3. Differences amongst institutions responsible for issuing monetary aggregates, normally the central bank and depository institutions. - 13 - - 14 - Measuring Money M1 – The monetary aggregate M1 is the narrowest measure of money. – Its definition is virtually the same for most countries. – M1 consists of currency as well as demand/sight deposits + other chequable deposits. M2 – The monetary aggregate M2 is broader than M1. – Its definition differs considerably from one country to another. – Usually, the savings deposits and most time deposits are included in M2 (on top of M1). - 15 - Measuring Money M3 – The monetary aggregate M3 is the broadest definition of money for the ECB (e.g., includes debt with longer maturity (< 2 years) in the definition of the ECB). – Its definition differs vastly from one country to another. – Many central banks (e.g., ECB and BoE) calculate and publish it. – However, a number of central banks no longer calculate and publish it (e.g., the Fed discontinued publishing the size of M3 in March 2006). - 16 - Which is the most accurate/useful monetary aggregate? Which monetary aggregate should central banks focus upon? o If the various monetary aggregates move closely together, it does not matter much which monetary aggregate is examined. o If they do not move together, then what one monetary aggregate tells us is happening to the money supply might be quite different from what a different monetary aggregate tells us: each monetary aggregate then is informative. Note that M3 is less affected by substitution between various liquid asset categories and is typically more stable than narrower definitions of money like M1. - 17 - Growth Rates of the M1 and M2 in the US, 1960–2020 - 18 - The Money Supply Process Three players are to be distinguished: 1. Central bank (CB): government agency that is responsible for the conduct of monetary policy (ECB, Fed, BoE, etc.). 2. Banks: depository institutions that take deposits and make loans such as commercial banks and savings and loan institutions (thus: not investment banks as they do not take deposits). 3. Depositors: individuals and institutions holding deposits at banks. - 19 - The CB’s balance sheet in stylised form Assets Liabilities Government securities (S) Currency in circulation (C) Loans to Banks (LB) Reserves (R) Monetary Base or high-powered money (MB): MB = C + R - 20 - The CB’s balance sheet in stylised form Liabilities Currency in circulation (C): in the hands of the public. Reserves (R): bank deposits at the CB and vault cash. Two categories: required reserves and excess reserves. Assets Government securities (S): holdings by the CB that are used to affect the money supply (see later) and earn interest. Loans to Banks (LB): provision of reserves or loans to banks by CB at the lending rate. - 21 - Control of the Monetary Base How can the amount of MB (= C + R) be influenced by the CB? 1. Open Market Operations (OMO): purchase or sale of existing government securities in the open market. 2. Loans to Banks (LB): loans to banks by the CB at the lending rate. The composition of MB can change as a result of currency and/or deposit withdrawals: shifts from deposits into currency or vice versa. - 22 - 1. Open Market Operations 1. Open Market Purchase by the CB from a Bank Banking System Central Bank Assets Liabilities Assets Liabilities Securities – 100 Securities + 100 Reserves + 100 Reserves + 100 Result: R  100 (C unchanged) => MB  100 2.1 Open Market Purchase from Non-Bank Public if NBP deposits the cheque Non-Bank Public Central Bank Assets Liabilities Assets Liabilities Securities – 100 Securities + 100 Reserves + 100 Deposits + 100 Banking System Assets Liabilities Reserves + 100 Deposits + 100 Result: R  100 (C unchanged) => MB  100 - 23 - 1. Open Market Operations 2.2 Open Market Purchase from Non-Bank Public if the NBP immediately cashes the cheque Non-Bank Public Central Bank Assets Liabilities Assets Liabilities Securities – 100 Securities + 100 Currency + 100 Currency + 100 Result: C  (R unchanged) => MB  100 Thus: The effect of an open market purchase on reserves (R) depends on whether the seller of the bonds keeps the proceeds from the sale in currency or in deposits (effect on R is uncertain). An open market purchase always increases the monetary base (MB) by the amount of the purchase (effect on MB is certain). - 24 - 1. Open Market Operations The use of OMO is very attractive for central banks as OMO are completely controllable and thus the effect of OMO on MB is perfectly controllable by the CB. Indeed, it is the central bank that decides on the timing and the amount of purchases and sales. This obviously presupposes that bond markets are functioning well, i.e., that at all times buyers and sellers are present (we will come back to this next week). - 25 - 2. Loans to Banks 1 CB makes a loan to a bank that requests it Banking System Central Bank Assets Liabilities Assets Liabilities Reserves + 100 Loan +100 Loan + 100 Reserves + 100 Result: R  100 (C unchanged) => MB  100 2 Bank pays off a loan from CB Banking System Central Bank Assets Liabilities Assets Liabilities Reserves - 100 Loan - 100 Loan - 100 Reserves - 100 Result: R  100 (C unchanged) => MB  100 - 26 - 2. Loans to Banks Loans to banks have a certain effect on the MB. However, central banks do not have full control over them. Indeed, central banks have perfect control over the conditions at which they are willing to lend (the amount and nature of collateral that is required, the lending rate that is to be paid, etc). However, it is up to banks to demand or not to demand loans from central banks (i.e., the amounts are at the discretion of the banks). - 27 - Currency and/or deposit withdrawals The effects of a deposit withdrawal, i.e., a shift from deposits into currency: Non-Bank Public Central Bank Assets Liabilities Assets Liabilities Deposits – 100 Currency + 100 Currency + 100 Reserves – 100 Banking System Assets Liabilities Reserves – 100 Deposits – 100 Result: R  100, C  100 => MB unchanged (only a change in the composition of MB). - 28 - Non-Borrowed Monetary Base The monetary base MB thus consists of two components that differ in terms of controllability by the CB: MB = MBn + BR, with MBn = the non-borrowed monetary base (consequence of OMO); BR = the borrowed reserves (consequence of borrowing from the central bank). - 29 - Moving from the Monetary Base to the Monetary Aggregates How does an action of the central bank (e.g., an open-market purchase) that affects MB ultimately affect the money supply M1? 1. Deposit multiplier model; 2. Money multiplier model. - 30 -  1. Deposit Multiplier Model: The Simple Model Step 1: Open Market Purchase of $100 million by the Fed from First National Bank First National Bank Assets Liabilities Securities – 100 Reserves + 100 Step 2: First National Bank uses the reserves to make loans First National Bank Assets Liabilities Reserves – 100 Loans + 100 Step 3: Borrower of First National Bank spends loan in favour of deposit holder of Bank A Bank A Assets Liabilities Reserves + 100 Deposits + 100 - 31 - 1. Deposit Multiplier Model: The Simple Model Step 4: Bank A makes loan after holding required reserves (r = 10%) Bank A Assets Liabilities Reserves + 10 Deposits +100 Loans + 90 Step 5: Borrower of Bank A purchases goods and services with the loan in favour of a deposit holder of Bank B Bank B Assets Liabilities Reserves + 90 Deposits +90 Step 6: Bank B makes a loan and the process continues towards bank C, D, E, etc Bank B Assets Liabilities Reserves + 9 Deposits + 90 Loans + 81 - 32 - Table 1 Creation of Deposits (Assuming 10% Reserve Requirement and a $100m Increase in Reserves) Bank Increase in Deposits ($) Increase in Loans ($) Increase in Reserves ($) First National 0.00 100.00 m 0.00 A 100.00 m 90.00 m 10.00 m B 90.00 m 81.00 m 9.00 m C 81.00 m 72.90 m 8.10 m D 72.90 m 65.61 m 7.29 m E 65.61 m 59.05 m 6.56 m F 59.05 m 53.14 m 5.91 m................ Total for all banks 1,000.00 m 1,000.00 m 100.00 m - 33 - 1. Simple Model: Deposit Multiplier Deriving the formula that links MB to M1: R = RR = r  D (assuming r to be constant) 1 D = R r 1 D =  R 1 / r = deposit multiplier r ΔD = change in total deposits r = required reserve ratio ΔR = change in reserves - 34 - 1. Simple Model: Deposit Multiplier Consequences of an open-market purchase of $100m for the banking system as a whole: Assets Liabilities Securities – 100 Deposits + 1000 Reserves + 100 Loans + 1000 Shortcoming of the Simple Model: Multiple deposit creation is reduced if 1. Banks hold excess reserves (ER) or ER > 0; 2. Proceeds from loans are partly kept in currency (C) or C > 0. - 35 - 2. The Money Multiplier Model The money supply process thus is more complicated than what it looks like within the Simple Model. The Money Multiplier Model extends the Simple Model with the: 1. Banks’ decision on the level of excess reserves (ER) Assumption: ER = e  D (e = excess reserve ratio) 2. Depositors’ decision on currency holdings (C) Assumption: C = c  D (c = currency ratio) - 36 - 2. The Money Multiplier Model Money Multiplier M = money supply M1 m = money multiplier M = m  MB MB = monetary base Deriving the Money Multiplier R = total reserves R = RR + ER RR = required reserves RR = r  D and ER = e  D ER = excess reserves R = (r  D) + (e  D) r = RR/D = required reserve ratio e = ER/D = excess reserve ratio Adding C to both sides c = C/D = currency ratio R + C = MB = (r  D) + (e  D) + C D = deposits MB = (r  D) + (e  D) + (c D) C = currency = (r + e + c)  D - 37 - 2. The Money Multiplier Model 1 D=  MB r+e+c M= M1 = D + C = D + (c  D ) = (1 + c)  D 1+c M=  MB r+e+c 1+c m = m = money multiplier r+e+c - 38 - 2. The Money Multiplier Model m 1 - 39 -  2. The Money Multiplier Model Numerical example Required reserve ratio => r = 10 % Excess reserve ratio => e = 10 % Currency ratio => c = 20 % m = (1 + 0.2) / (0.1 + 0.1 +0.2) = 3 Note in the Simple Model, the deposit multiplier was substantially larger than 3 => 1 / r = 1 / 0.1 = 10. - 40 - Factors Affecting M1 in the Money Multiplier Model 1+c M = MB and also M = m (MBn + BR) where MB = MBn + BR r+e+c MBn = non-borrowed MB (controlled with OMO by the CB); BR = borrowed reserves from the CB (under banks’ discretion). 1. Changes in MBn (MBn , MB , M ) 2. Changes in BR (BR , MB , M ) 3. Changes in the required reserve ratio, r (r , m  , M ) 4. Changes in the currency ratio, c (c , m  , M ) 5. Changes in the excess reserve ratio, e ( e , m  , M ) - 41 - - 42 - Factors Affecting M1 in the Money Multiplier Model Confirming the negative relation between r, e and c on the one hand and m on the other hand via first derivatives: 1+𝑐 𝜕m 𝜕 𝑟+𝑒+𝑐 1+𝑐 1. = =−